How Wal-Mart Made Its Crumbling China Business Look So Good for So Long

After years of heralding China as one of its best markets, Wal-Mart in August said its performance there was among the worst in its major countries. A management shake-up and job cuts have followed.

Although the reversals seem abrupt, cracks in the foundation of Wal-Mart’s retail business in China have been developing for years, hidden by questionable accounting and unauthorized sales practices, according to employees and internal documents reviewed by Bloomberg.

The practices — including bulk sales to other retailers and some sales allegedly booked when no merchandise left the shelves — made business appear strong even as retail transactions slowed and unsold inventory piled up, these people and documents say. Wal-Mart said in August that it was unhappy with inventory growth internationally.

Stores in China continue to make bulk sales, sometimes unprofitably and without required management authorizations, according to employees who’ve left the company this past month. Concerns about bulk sales, raised as far back as 2011 in an internal report, have been the subject of inquiries in China by Wal-Mart’s legal team as recently as May, according to an internal company e-mail and an employee interviewed by lawyers.

The report and interviews with current and former employees say Chinese Wal-Mart stores, under pressure to meet earnings targets, resorted to temporary markups of inventory as an accounting move that can burnish profits without any added sales of merchandise.

Extensive Investigation

After employees “recognized inventory pricing discrepancies” in 2011, the company’s senior leadership in the U.S. and China ordered an extensive investigation that led to “various leadership changes and disciplinary actions,” strengthened compliance measures, training, and regular audits, Wal-Mart Stores Inc. said in a statement.

“None of the financial issues we’ve reviewed in China were determined to be material to Wal-Mart’s consolidated financial condition or results of operations,” the statement said.

Wal-Mart didn’t address specific questions on accounting issues, and leadership changes. It said bulk sales to retailers are common practice in developing markets, monitored regularly, and a modest part of its Chinese business.

Four top managers of Wal-Mart China left the company in 2011, including Ed Chan, then chief executive officer for the country. Chan, now vice chairman of C.P. Lotus Corp., a retailer based in Hong Kong, said the reason he left was known only to him and Wal-Mart and was unrelated to price markups or bulk purchases. At the time, Wal-Mart said he left for personal reasons.

Ethics ’Flexibility’

The bulk sales provided at least 1.6 billion yuan ($243 million) in sales, and the markups accounted for 4 percent of gross profits in 2010 alone at 98 hypermarket stores examined by Stanford Lin, who conducted the internal review. These stores accounted for about half of total hypermarket sales in China that year.

At the time, Wal-Mart was looking to growth abroad to make up for a slowdown in the U.S.

“There is a general flexibility on ethics” in China, Lin said in an interview. “There was a huge desire to perform. In this market, they believe if they’re hitting the numbers, then they’re doing the right thing.”

Lin left Wal-Mart last year, and became head of Chinese operations for Visa Inc. in Shanghai.

Markup Time

By 2010, the year of Lin’s review, the U.S. was just emerging from recession. While Wal-Mart’s Chinese operations were expanding, the stores weren’t running as profitably as those operated in the U.S. by the Bentonville, Arkansas-based retailer.

As a newly minted member of Wal-Mart’s Strategy and Innovation Team, Lin, a former McKinsey & Co. consultant, was assigned to look for ways to improve productivity. What he found was a Chinese operation veering out of control.

Lin traveled across the country asking workers in the hypermarkets — vast, we-sell-it-all arcades roughly equivalent to Wal-Mart’s core superstores in the U.S. — what kind of activity was wasting their time. Markups, they told him: hours spent putting higher prices on thousands of goods — from DVD players to vintage liquor. Managers often told employees to raise prices in the last week of the month, and to move them down at the start of the next month.

Highly Confidential

The employees couldn’t understand why. Higher prices, even if temporary, didn’t jibe with the everyday-low-pricing strategy that founder Sam Walton and his successors used to turn his Arkansas five-and-dime into the world’s biggest retail chain, with more than $480 billion in annual sales.

The markups were part of a pattern of “unusual,” unauthorized, and “unsustainable,” accounting moves and deals with suppliers and rivals that made sales and profits look stronger than the underlying retail trends in the stores, according to Lin’s 32-page review, labeled “Highly Confidential.”

“The business was continually getting worse despite their pronouncements to the contrary,” Lin said earlier this year.

The February 2011 review and interviews with current and former Wal-Mart employees raise questions about how the company has booked results in the world’s second-biggest economy. They also cast new light on Wal-Mart’s degree of success in China — which the company called a standout in the period Lin covered.

Deflationary Pressure

China “drove the strong sales performance” of the international division, Wal-Mart told investors in May 2010. Eight days after Lin’s written review, Wal-Mart said in a conference call that China was among countries with the highest sales increases in its fiscal year ended Jan. 31, 2011.

Now, it is one of the weaker links. Net sales fell in China in the company’s fiscal quarter ended Oct. 31, which it said was “due to retail deflationary pressure.” The company has said it will close about 30 of roughly 400 Chinese stores, and on Dec. 2 it said it is shedding 250 jobs in China, mostly in merchandising and marketing.

There will be 6,000 new jobs created with the opening of 31 new stores and distribution centers this year, the company has said.

The U.S. Department of Justice and the Securities and Exchange Commission have been investigating Wal-Mart for possible violations of the Foreign Corrupt Practices Act, the company has disclosed. Internal investigations of possible misconduct are open in four countries, including China, the company has said.

It isn’t known whether the practices described in Lin’s report are part of the inquiries under the act, which has a section on the integrity of books and records. The company has said it is cooperating with investigators. Wal-Mart declined to comment on the inquiry.

Footprint Growing

Altering reported income by marking up inventory “only to turn around and mark it down again” after the end of the quarter “would be fraud,” said Lynn Turner, a former chief accountant for the SEC and now a managing director at LitiNomics Inc., an advisory firm in Los Angeles. Turner was speaking generally, and not about Wal-Mart.

Wal-Mart entered China in 1996. After opening 56 stores in its first 10 years, the company hired Chan as CEO in 2006. Educated in the U.S., and formerly with McKinsey, he was familiar with American business practices, and driven to enlarge the retailer’s footprint in China, colleagues said.

By 2008, the store count hit 200 and China had become a profitable market. In 2009 Forbes China named Chan among its “People of the Year.”

Chan operated under the company’s “freedom within a framework” policy that allowed executives to run their own areas without interference, according to those who worked for him. He allowed his deputies to handle the day-to-day running of the business while keeping them focused on meeting profit goals, which helped decide raises and promotions, they said.

Label Swaps

Chan had been the boss in China for two years when Doug McMillon, now Wal-Mart’s chief executive officer, became head of international operations. An Arkansas native, McMillon rose through the ranks from a store level-job to merchandising posts and a stint running the Sam’s Club warehouse division. Within three months of taking over international, McMillon told investors that it needed to be more productive.

Lin, fluent in English and Mandarin, and schooled in the U.S. like Chan, said he was hired to root out inefficiency and reduce head counts. The time spent on markups quickly caught his attention.

When buyers asked stores to change prices, they had 24 hours to comply — often scrambling to swap out labels on 1,000 or more products, according to one former operations executive for Wal-Mart China.

Department 14

After widespread end-of-month markups in 2008, customer complaints about the unpredictability of Wal-Mart pricing came up at one of the meetings of senior managers that Chan attended, this person said. He said he never heard from anyone about following up.

In his report, Lin highlighted “Department 14,” or housewares. He said the division marked up 183 products in the last week of December 2010, increasing gross profits by 2.5 million yuan. In the first week of January 2011, the products were marked back down.

It was an accounting entry, not added sales, that was behind these higher profits, according to Lin.

In simplified retail accounting, gross profits are sales minus the cost of goods sold. The cost figure can be calculated by subtracting ending inventory from beginning inventory. Lin’s report said the price markups were applied to ending inventory, giving the appearance of lower costs.

High Targets

Hypothetically, say a store had $20,000 of wine at the start of a month, and was left with $10,000 worth at month’s end. Its cost of goods sold would be $10,000. If sales were $15,000, gross profits would be $5,000. But if ending inventory is marked up 20 percent, the cost of goods sold drops and wine profit rises to $7,000.

At Wal-Mart China, profit and sales targets, established by headquarters, were high, and so was the pressure to hit them, according to Samuel Guo, a former purchasing manager for home and seasonal products. Guo said his supervisors would send weekly reminders telling employees where they stood on margin targets and other key performance indicators. He said he didn’t see any end-of-the-month markups in his division.

Wal-Mart was also facing increasing competition from multinationals like France-based Carrefour SA, and local chains including Sun-Art Retail Group Ltd., backed by another French company, Groupe Auchan SA. Wal-Mart’s struggling to attract more ordinary Chinese consumers often turned to unprofitable bulk sales to improve their numbers, several employees said.

Wal-Mart was the third-largest hypermarket operator in China last year with a 10.4 percent market share, according to Euromonitor International. The stock fell 0.7 percent to $82.98 at the close of trading Wednesday in New York.

Pressure

“The store was under a lot of pressure from the HQ to meet certain sales and margin targets every month,” said Tom Huang, an administration manager at the Wal-Mart in the city of Changde, which closed in March.

At around 8 p.m., when sales were slow, store-level managers responsible for various product categories would call wholesalers and “ask them to come down and buy” items in bulk, said Huang, a union representative who has been involved in legal efforts to get more severance for the laid-off Changde workers.

The company was losing money on bulk sales of groceries and barely selling above cost on a range of other products, Lin’s report said. Bulk transactions of 10,000 yuan and above were supposed to be approved by store managers, but to avoid the sign-offs, employees would simply break them up into smaller lots ’’against company policy’’ — in one case splitting up a sale of 9,600 bottles of soybean oil into 32 separate transactions, Lin said.

Dove Chocolate

More recently, company purchasing managers would ask their product buyers each month whether they’d arranged enough bulk sales, one regional buyer said. The buyers would sell large quantities of products such as Dove chocolates, chewing gum and toilet paper to smaller wholesalers and mom-and-pop stores, the Wal-Mart buyer said.

In some cases, a store would register a sale to a supplier of the same goods the vendor had previously sold to Wal-Mart — but the goods didn’t go anywhere, according to Lin. Recording the transaction would automatically trigger Wal-Mart’s ordering system to place a new order for the same goods, he said.

A sale like that is “a plan designed to mislead. It’s inflating sales,” said Douglas Carmichael, former chief auditor of the Public Company Accounting Oversight Board and a professor at Baruch College in Manhattan. ’’It certainly would create a distortion of the income statement.’’

Orders Rise

To make up for the losses and low-margins earned on bulk sales, Wal-Mart product buyers looked to suppliers for help in the form of fees including cash rebates, according to Lin’s review and three former and current employees. Suppliers’ agreement to pay the rebates often came with “quid pro quo” commitments by Wal-Mart to order more merchandise, driving inventories even higher, Lin’s report said.

During U.S. earnings calls throughout Chan’s tenure, Wal-Mart’s Bentonville executives highlighted Chinese sales performance. In August and November of 2008, the company said same-store sales in China were strong and driven by increases of up to 18 percent in the size of the average transaction — a sign that growth mostly stemmed from big sales.

No mention was made of sales of Wal-Mart merchandise to other retailers. In fact, individual customer traffic was beginning to fall, and transactions in the hypermarkets Lin examined fell 3 percent from 2008 to 2010.

Inventory Issue

As employees threw their efforts into making margins and sales look healthy, storage rooms were filling up. In 2010, month-ending inventory at the stores Lin studied was 12.3 percent higher on average than in 2009, while sales rose 8.3 percent. Unsold merchandise piled up inside stores and in storage containers behind them, according to one former executive in Wal-Mart Asia, who asked for anonymity to discuss an internal matter. He said warehouses were added across the country in 2009 and 2010.

Wal-Mart’s goal for years has been to keep inventory expanding at or below the rate of sales growth. The company said in August that it was disappointed that internationally inventory growth was outpacing sales.

In a superstore in Shenzhen, stock has been building up over the past 20 months or so, said Zhang Liya, who has worked for Wal-Mart for nearly a decade. Zhang said the inflow of produce, meat and other food has overwhelmed workers because there has sometimes been no place to put it.

Packed Room

A back room at one South China store shown to Bloomberg News in September held boxes of goods piled to the ceilings, covering light switches and leaving only a foot-wide aisle for employees to move around in. A Wal-Mart store in Shenzhen provided an address for a warehouse one employee said was opened to handle added inventory five years ago. At the address, a security guard said Wal-Mart had two warehouses there.

When the findings of his Feb. 14, 2011, report were presented to his boss, Shawn Gray, then vice president of operations in China, Gray said the “best option was to keep things quiet,” according to Lin. After a discussion of the issues with Roland Lawrence, then chief financial officer of Wal-Mart China, Lin said he saw no action.

Lin then turned to Clara Wong, who was chief of human resources in China and also dealt with ethics issues, he said. After that, an investigating team from Bentonville arrived in China, interviewed Lin off-site for a full day, and imaged his laptop to scan for communications from senior leadership about the accounting issues, he said.

Personal Reasons

Another Wal-Mart delegation, including Scott Price, the company’s Asia CEO, arrived at the Chinese headquarters in Shenzhen later and met with the top management there.

Wal-Mart said in May 2011 that Rob Cissell, its chief operating officer in China, and Lawrence had left the company to “seek new development opportunities.” The next month, Wal-Mart announced Gray, vice president of operations in China, left the company for “personal reasons.”

Cissell said he left Wal-Mart to take another job, and that his departure had nothing to do with any internal report or allegation. He is now chief executive officer at Big C Supercenter, a retailer based in Bangkok, Thailand.

Lawrence is now vice president of finance for Asia at Denmark-based Carlsberg Breweries A/S. Gray is chief operating officer at Reliance Retail, based in Mumbai, India.

Wal-Mart named Lin as a vice president of financial services in April 2012. He left in May 2013 for his job with Visa. Lin said he traveled to Bentonville at one point after the report and bumped into Price and McMillon, who, through a Wal-Mart spokeswoman, declined to comment on Lin’s account.

“Doug took me aside, shook my hand and said, ’thank you very much for what you did over there,’” Lin said of the encounter. “That was it. No further follow-ups. Nothing more was discussed. It was like it all never happened.”